Thursday 6 February 2014 09.53 EST
First published on Thursday 6 February 2014 09.53 EST

Exactly 170 years ago, the UK government passed a law to deal with a banking crisis that was uncannily similar to the one we've just endured. Updating that law may hold the key to preventing the crisis from happening again.

The Bank Charter Act 1844 prohibited anyone other than the Bank of England from printing paper money. Before it was passed, high street banks had been handing out pieces of paper as receipts for the metal coins that people deposited with them. Over time, the paper receipts became accepted as being as good as the coins, and were used as though they were money. Borrowers would sign loan agreements and accept a piece of paper with the bank's name on it, rather than asking for coins issued by the Royal Mint. In a stroke of luck, bankers had acquired the power to literally print money.

Naturally, banks found it hard to resist the temptation to make more loans by simply printing more paper money. The credit bubble that resulted – and the subsequent bust – prompted the government to prohibit banks from creating money in the form of paper notes.

But the 1844 law was never updated to apply to electronic money and still only applies to paper notes. Metal coins and paper notes now make up just 3% of all the money in the UK. The remaining 97% of money consists of essentially numbers in high street banks' computer systems. Banks create this electronic money through a simple accounting process whenever someone takes out a loan.

In the decade preceding the financial crisis, banks created more than a trillion pounds of new money – and new debt – this way. Of this new money, 51% went straight into property, artificially inflating house prices, with salaries unable to keep up. A further 32% went into the financial markets, fuelling good times for the City but storing up problems for the future. Just 8% went to the non-financial businesses that create jobs and employment, and a further 8% went on personal loans and credit cards.

Now imagine if we updated the laws so that banks were prohibited from creating both paper and electronic money. Instead, electronic money could be created directly by the Bank of England and added to the central government's bank account. The government would then put that money into the real economy, through government spending or tax rebates.

It could even give everyone their equal share – an idea described as quantitative easing (QE) for the people. Instead of flooding property and financial markets, money created in this way could start its life in the real economy, boosting GDP and employment rather than inflating house prices and household debt burdens.

Some economists will worry about the effects of newly created money on inflation. But they forget that money is currently created every time a new loan is made, by bankers who have no interest in the effect of their lending on inflation. In contrast, the Bank of England would watch inflation and would hold off on creating money if it started to feed through into higher prices.

Government finances would receive a boost, as the Treasury would earn the profit on creating electronic money, instead of only on the creation of bank notes. The profit on the creation of bank notes has raised £16.7bn for the Treasury over the past decade. But by allowing banks to create electronic money, it has lost hundreds of billions of potential revenue – and taxpayers have ended up making up the difference.

These changes could also reduce household debt. In the current system, new money is only created when banks lend. Banks will only lend if someone is willing to go into debt. That is why the government wants to fuel growth by encouraging more household borrowing. But with household debt at its highest level in history, any further increase could lay the foundations for another financial crisis. Only the Bank of England has the ability to create new money without having to wait for someone to go into debt.

Banks would still exist, as providers of current accounts (which would hold money created by the Bank of England, rather than an uncertain IOU from a bank), and as middlemen between savers and borrowers. But they would lose the ability to create new money in the process of lending.

The idea of removing banks from their role as creators of the nation's money will strike many as radical. But it is surely more radical to entrust the same banks that caused the financial crisis to create the money on which the rest of the economy depends.